Brexit Q&A: Do all roads lead to an election?

The daily oscillation of Brexit noise has continued apace since our last update, with parliament embarking on a series of indicative votes to find an alternative to PM May’s Withdrawal Agreement in the coming days. This note highlights how the EU’s response to the UK’s request for Article 50 extension, May’s position as Prime Minister and the risk of general election are likely to see UK political fracture and chaos for the foreseeable future. We outline the changes to our Next Steps scenario analysis, though these are subject to further change following the indicative vote process as the febrile political environment makes it difficult to rule out any outcome.

What has happened since the last update?

While there has been much noise, the most tangible action was the PM’s request for Article 50 extension to June 30th. This was met by a more conditional response from the EU, specifying a short extension to April 11 to pass the Withdrawal Agreement (WA).

  • If May’s WA is passed, the EU will then provide an extension to May 22 for the UK to pass the necessary implementation legislation before moving into the transition period.
  • If the WA fails to pass, this extension is not guaranteed and the UK will need to provide details of how it intends to find a solution in order to justify extending Article 50, as well as holding MEP elections for any extension beyond May 22.
  • This conditional extension is very much in line with our base case for the EU’s approach to extension, given the clear desire in Brussels not to waste further months negotiating something that the UK parliament does not support. There had been hopes an alternative to MEP elections could be found but, while technically a loophole might be found, these elections should be taken as necessary until proven otherwise.

What would be required for a longer extension?

Technically, an extension to end June would be possible though we would strongly expect the EU to demand proof from the UK of how it intends to find resolution in that time. However, the EU has specified that if the UK wants an extension beyond May 22, the UK must participate in the EU Parliamentary elections.

  • The UK must declare its candidates by 12 April, hence the date for the initial extension period.
  • The optics of running EU elections three years after the UK voted to leave are deeply problematic for Theresa May and her government. This will significantly affect parliamentary dynamics in the next two weeks.
  • For many Conservatives, the risk of EU elections might encourage them to support May’s WA as the lesser of two evils. We do not think May would govern over fresh EU elections adding to the risk of an interim leader or fresh leadership elections in the short term.
  • However, so long as the majority against No Deal holds, in a scenario where a longer extension is needed, we think these would have to go ahead. Commitment to avoiding No Deal will become clear in the coming two weeks as the April 12 deadline approaches. However, we do not believe May would be happy to lead the party in the context of MEP elections, resulting in interim leadership and a potential general election.

So is the deal going to pass?

We assign a 20% likelihood that the Withdrawal Agreement passes; down 10% since our last update.

  • The reason for this change is a combination of ongoing ERG opposition to the deal with little signal of softening relative to our last update. The fact that the government is delaying voting on the WA reflects the lack of support it sees among its own party and more broadly.
  • Nonetheless, the scenario retains 20% probability because the trade-off remains the same for pro-Brexit Conservatives: choose this deal or risk a softer Brexit, particularly now that the indicative vote process is on the table.
  • There are rumours that May could offer to resign as leader if ERG members back her deal. While this is likely to sway a number of ERG members, the group is very large and disparate (as discussed in previous notes) which makes it difficult to predict whether she could gain all of their support.

What is the indicative vote process that parliament has agreed?

In line with our expectations, parliament has approved a motion to hold indicative votes to try to find a majority-approved solution to the impasse.

  • The motion passed with a majority of 27, which required 30 Conservative MPs to defy the government whip. The precise options to be included in the indicative vote process have not yet been defined and the process by which it is determined is also unclear. The voting process will be crucial to determining the most likely outcomes, so probabilities in our next steps analysis will be reviewed once the voting system is confirmed.
  • For any alternative solution to be binding in the absence of government support, parliament would need to issue legislation without government support. This is possible so long as a majority can be commanded by the alternative solution.
  • Among the options for indicative vote, we expect at least to see remaining in a ‘Customs Union’ and ‘Norway plus Customs Union’. Additionally would could see a Canada style FTA; potentially a second referendum; and even possibly May’s deal. The options will become clear in the next 24 hours.

What are the chances of an indicative vote option breaking the gridlock?

  • We think a guarantee to remain in the Customs Union would be the most obvious compromise, assigning 20% to that likelihood. However, it does violate Conservative party red lines on Brexit so is likely to create substantial disruption if pursued.
  • This might prompt Conservative MPs to support the government’s deal or it could risk triggering a general election to gain a new mandate for Brexit from the people. Additionally, it risks not being the favourite option in a preferential voting system as pro-Remain MPs are likely to back ‘Norway Plus’ or a second referendum first.
  • ‘Norway Plus’ is also being widely discussed by opposition parties. It would be disastrous for the Conservative party as it does not satisfy any of the Brexit asks for free trade and free movement of people.
  • We have increased the probability of passage to 15% because it is garnering substantial opposition party support so could do well in a preferential vote system. We will be looking for signs that Conservative Remainers are willing to completely ignore the party line as this would see the probability increase substantially.
  • If the indicative votes fail to find a majority, we expect May to try to get her deal through again given the short time remaining to April 11. Alternatively, if a slim majority is found for a softer Brexit, May could offer her WA as an alternative. For Conservative pro-Brexit ministers, the WA may be the lesser of two evils.
  • Additionally, the risk with the indicative votes system is that it triggers a general election by dissatisfied Brexiteers to avoid a softer Brexit. This is part of the reason that a general election as a next step garners 20% of probability in our next steps scenarios.

What about Bercow’s ruling that May’s deal cannot be brought back again and again?

Our view is that Bercow’s ruling (that the Withdrawal Agreement cannot be brought back to parliament unchanged) is not a binding constraint if a solution has a solid majority in Parliament.

  • The fact that the terms of the Article 50 end date has changed following the short extension is likely to allow May to hold a meaningful vote on her Withdrawal Agreement with permission of the House.
  • However, if May decides to bring the WA back for a fourth vote, Bercow may argue that she cannot put the same bill to parliament twice.
  • The government could circumvent the ruling but would need a majority to do it. So it all comes back to the need for May to find a majority; if she manages that, the Bercow ruling is no longer a constraint.

How fragile is May’s position as Prime Minister?

Extremely. We think that not only is her position more tenuous than ever, the risk of a general election has also risen substantially as the Conservative party continues to fracture over Brexit.

  • Trust in May is at an all-time low among cabinet members and MPs. The fact that her resignation is seen as a sweetener to her WA passing and the fact that 30 MPs defied the government whip to support a motion for indicative votes demonstrate this on both sides of the Conservative party.
  • However, it is not only her position but also the Conservative government itself that is in jeopardy. If parliament cannot find a solution and May blocks a constructive resolution and further extension, we think her government would fall.
  • This reflects both May’s weak support levels and parliament’s opposition to No Deal. If the PM drifts towards No Deal, we would expect Conservative Remainers to abandon ship rather than risk a cliff edge.

If the Withdrawal Agreement passes or some alternative, does the risk of general election fall away?

We think that a general election remains elevated in the next 12 months whatever the outcome. If ‘Customs Union’ or ‘Norway Plus’ is approved by parliamentary indicative votes, we think the second round effect would be a sharply heightened risk of general election.

  • As discussed, May’s resignation may be a prerequisite for getting her deal passed. However, even if she doesn’t offer to resign beforehand, we would expect her to do so after.
  • If the new Conservative leader is a more hard-line Brexit supporter, the Conservative party is likely to further splinter and risk losing its slim majority. Additionally, a new leader may wish to return to the people to gain a fresh mandate after months of erosion of the party’s political capital.
  • If a deal cannot be reached, we would expect May to step down. An interim leader may oversee a change in process, which would likely need to be substantial in order to secure an orderly withdrawal. However, in these circumstances, a fresh mandate would also likely be required to move forward.
  • We would warn that the current Labour leadership is likely to create significant uncertainty for investors when the next election comes. The Labour party is, on average, polling lower than the Conservative party. However, the context in which a general election is called (e.g. amid an inability for Conservatives to come together over a Brexit deal) and the campaign process itself – as evidenced in 2017 – may see those polls shift substantially.
  • We recently provided scenario planning for a successful Labour election campaign:

Brexit Next Steps Scenarios

Brexit-QandA-next steps

Corbyn scenario planning

General Election Risk Planning: Labour Party Government

This note assesses the impact of a general election and Labour party government being in place on a maximum six month time horizon. Although not our base case, if a general election is called in the coming months, our asset class experts expect the campaign period to be highly risk-off for the UK market as fears of a shift in government policy towards selective nationalisation and less business-friendly policy under the Labour party overshadow any potential relief about the party’s softer Brexit policy.

A major risk-off move from markets, if severe enough, could challenge the outlook for inflation, growth and BOE policy. However, elements of Labour party policy could be net stimulatory for GDP short-term and infrastructure investment could improve long-term outlook if well-targeted. Additionally, parliamentary support for Labour’s more problematic policies should not be taken for granted; Governments frequently do not pass all policies included in a campaign manifesto. If the Labour party is elected to government, the size of its majority, ideology of MPs and initial actions by the government will determine whether major disruptive policy change comes through as markets fear.

Scenario Planning Exercise

Time horizon:
6 months (December 2018 – May 2019)

Assumptions:
A general election is triggered in or before January.
Polling day is in ~March.
Markets anticipate government behaviour based on campaigns and early government actions.
Polls suggest clear Labour party support, so markets price the risk through the campaign.
Article 50 extension is granted to allow the UK to hold its general election. This extension is somewhere between 3 – 9 months.
Economic impact is inferred based on market views set by asset class specialists. The final section discusses the pure economic impact of these policies separately.

How would markets react to a snap election?

There is a distinct difference between how markets price during a snap election campaign versus the reality of a Corbyn-led Labour party government. Our investment teams in FX, gilts and credit expect a sell-off in risk markets during an election campaign. Sterling trade-weighted is estimated to fall by as much as 15% during a campaign at the prospect of a Corbyn-led government while gilts would be expected to rally to 1% and credit spreads widen to 200bps. Factors that will affect the extent of the risk off move include Labour party polling, the prevalence of Brexit concerns and policy focus during the campaign.

What would happen if Corbyn actually became Prime Minister?

Given the compressed timeline of six months, investors would only have around two months of Labour government so a large degree of caution is likely to remain priced in, particularly in credit markets. However, early signals of the new government’s intentions would be key for investors. The scenarios table outlines three versions of a Labour party government, with waymarks and market impact embedded for each.

If Corbyn was to use his platform to push a policy agenda that appeared business-unfriendly, such as the 10% share return to workers and selective nationalisation, and has a large majority of like-minded Labour MPs, markets are likely to react aggressively. However, if the new government pushed infrastructure and a softer Brexit or if the government has only a small majority with a mix of centrist and Corbyn allies, asset pricing is expected to move to price a lower risk.

It is worth bearing in mind that major policy change that challenges business-as-usual is complex and challenging to pass in parliament. Governments frequently do not pass all policies included in a campaign manifesto. Some areas have more room for interpretation by the Prime Minister, such as existing regulation in sectors like financial services, but cases of substantive change would likely face challenge, particularly if the government majority is small.

An additional factor, though not embedded in the scenarios below, is the responsiveness of a Corbyn-led government if markets sharply underperform, creating a potential softening in the pursuit of more unorthodox policy measures. Crucial to this will be the size of the Labour party majority in such a scenario and the ideology of the MPs in that majority; the more Corbyn allies in the government, the greater the likelihood he can implement more extreme policies.

Brexit-QandA-scenarios

What would a Labour party government mean for the economic outlook?

Fresh elections would bring a fresh manifesto but we would expect them to be similar to the 2017 campaign promises. Labour’s plans in 2017 represented a material shift in fiscal policy. The manifesto proposed a sizeable rise in current expenditure, reversing several years of austerity. A larger state would be partly paid for by tax hikes for higher earners and companies, although investment will be funded through borrowing. Taken together this would boost short-term growth (all things remaining equal), and well directed investment spending can help raise the growth potential of the economy (although the manifesto provided worrying signals that spending will be politically focused).

The party’s proposals to tighten labour and product market regulations risk creating material economic distortions and inefficiencies. However, there are some important nuances in the party’s policy mix. Labour party living wage policies, while undermining margins for affected firms, would positively impact consumer demand. Similarly, if Labour rolls back the welfare cap, the marginal propensity to consume they could be high, though crowding out effects will likely come into play Since the election, Labour proposals to return 10% of shares to workers and the government have startled market participants; John McDonnell, Shadow Chancellor, since rowed back on the proposal offering to work with business to find a solution. However, disruptive policy measures could challenge the growth outlook if risk markets reacted aggressively, causing tighter financial conditions. The Bank of England may find its ability to ease policy in this environment constrained by the inflationary pressure that would be associated by the likely fall in sterling. However, Labour’s proposals could also see upward pressure on interest rates if the short term boost from fiscal easing was thought to outweigh any shock to confidence and asset prices.

McDonnell recently commissioned a report on the future on monetary policy, the main finding of which was that the Bank of England should have a larger role in guiding investment towards productivity enhancing activities. There is a possibility that investors could interpret this move as an excessive politicisation of monetary policy and could undermine confidence in the credibility of the inflation target at the margin. This could see a higher risk premium in gilts and other sterling assets. Signals on the EU were vague in 2017, but the tone suggested that Labour could pursue a softer Brexit. Since the election, the Labour party has confirmed customs union membership with as much single market as possible as its desired end state. If the party campaigns on this policy, the risk of no-deal reduces significantly. Although some Labour MPs may rebel given the divisions in the party, inclusion of a policy in the campaign will tie most MPs to this policy with potential marginal additional support from pro-remain MPs in other parties. This along with the lack of an immigration target would be positive for long-term growth prospects.

An additional factor, though not embedded in the scenarios below, is the responsiveness of a Corbyn-led government if markets sharply underperform, creating a potential softening in the pursuit of more unorthodox policy measures. Crucial to this will be the size of the Labour party majority in such a scenario and the ideology of the MPs in that majority; the more Corbyn allies in the government, the greater the likelihood he can implement more extreme policies.

Appendix 1: Labour Policy Agenda from 2017

Brexit-QandA-labour agendas

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